Is it a mistake to insist that CEO pay be performance-based?

It goes without saying that, to many, the sine qua non of executive compensation is performance-based pay. From proxy advisory firms to institutional holders to the drafters of Dodd-Frank, the question of whether CEO compensation is aligned with performance is a key measure of whether compensation is appropriate. As a result, often 60 to 80% of CEO pay is performance-based. But in a recent essay in the Harvard Business Review, two academics contend that performance-based pay for CEOs makes absolutely no sense: research on incentives and motivation suggests that the nature of a CEO’s work is unsuited to performance-based pay. Moreover, “performance-based pay can actually have dangerous outcomes for companies that implement it.” Why not, they propose, pay top executives a fixed salary only?

The global economic crisis of 2008 led many to question whether large bonuses and stock options were motivations behind the overly risky behavior and short-term strategies that many argue triggered that crisis. But the answer that most often resulted was to structure the compensation “differently so that the variable component motivates the right behaviors.” Instead of changing the measures, these two academics “argue in favor of abolishing pay-for-performance for top managers altogether.” Their argument is based on five data-driven points:

Contingent pay works only for routine tasks. Research has shown that, while performance-based pay works well for routine tasks, the types of work performed by CEOs are typically not routine; performance-related incentives, the authors argue, are actually “detrimental when the [task] is not standard and requires creativity.” Where innovative, non-standard solutions were needed or learning was required, research “results showed that a large percentage of variable pay hurt performance.” Why would that be? In this interview from the Washington Post, one of the authors explains that the research shows that “for humans in general, performance-related pay often backfires. That seems slightly counterintuitive. But if a very large component of someone’s pay is dependent on performance — and hence there’s a lot at stake — people seem to freeze.”

SideBar: As discussed in this PubCo post, a New Yorker columnist concurs with the contention that performance pay does not really work for CEOs because the types of tasks that a CEO performs, such as deep analysis or creative problem solving, are typically not susceptible to performance incentives: “paying someone ten million dollars isn’t going to make that person more creative or smarter. One recent study… puts it bluntly: ‘Higher pay fails to promote better performance.’” In addition, the argument goes, performance is often tied to goals that CEOs don’t really control, like stock price (see this PubCo post and this news brief.)

Fixating on performance can weaken it. While most performance-based pay is designed “to focus leaders on hitting goals and achieving outcomes[,] as researchers have found, if you want great performance, performance is the wrong goal to fixate on.” Indeed, the authors maintain, performance or outcome goals “can have a deleterious effect on performance.” Rather, research has shown that a better way to achieve performance is for employees to “frame their goals around learning (i.e., developing a particular competence; acquiring a new set of skills; mastering a new situation)[. This approach] improves their performance compared with employees who frame their work around performance outcomes (i.e., hitting results targets; proving competence; seeking favorable judgments from others).” Why are learning goals more effective? “[P]recisely because they do the opposite of most executive incentives: they draw attention away from the end result and focus instead on the discovery of novel strategies and processes to attain the desired results. Therefore, focusing top managers’ attention on the end result – by tying rewards to performance goals – is counterproductive: it prevents people from learning and developing something new.”

Intrinsic motivation crowds out extrinsic motivation. According to the authors, intrinsic motivation – doing something for your own satisfaction and sense of achievement – “is fundamental to creativity and innovation.” Extrinsic motivation – doing something for bigger financial rewards, for example – diminishes intrinsic motivation: “A meta-analysis of 128 independent studies conclusively confirmed this effect. Although all studies have methodological shortcomings, the consistency of the results across so many studies, samples, and methodologies is noteworthy. As noted by the authors [of the meta-analysis], ‘expected tangible rewards made contingent upon doing, completing, or excelling at an interesting activity undermine intrinsic motivation for that activity.’ Because intrinsic task motivation is fundamental to creativity and innovation, highly variable incentives deplete top managers of the intrinsic motivation they so much need to perform optimally.” And, the authors contend that, if the company believes that a high proportion of variable pay is necessary to attract top executives, the result may be that the company attracts those who are extrinsically motivated instead of those who are intrinsically motivated.

Contingent pay leads to cooking the books. According to authors, when “people are largely motivated by the financial rewards for hitting results, it becomes attractive to game the metrics and make it seem as though a payout is due. For example, different studies have shown that paying CEOs based on stock options significantly increases the likelihood of earnings manipulations, shareholder lawsuits, and product safety problems. When people’s remuneration depends strongly on a financial measure, they are going to maximize their performance on that measure; no matter how.” The effect of unethical behavior is exacerbated when “people fell just short of reaching their goals – a common outcome of the oh-so-popular ‘stretch goals.’ Thus, cooked books, false sales reports, and illegal means to performance emerge when financial incentives cause leaders to care more about looking good in terms of results than actually doing well in terms of creating value.” In the interview, the author observed that these “negative effects seem to permeate the whole organization, starting from the top down.”

SideBar: As discussed in this this PubCo post, a recent study showed a correlation between a high proportion of stock options relative to total CEO pay and the incidence of serious product recalls. The reason for this result, so the argument goes, is that stock options fuel excessive risk-taking behavior among executives: according to the study authors, their “‘results are consistent with prior research showing that option-heavy pay arrangements engender aggressive risk-taking by CEOs, who stand to benefit greatly from future increases in share prices but lose nothing if share prices fall.’ The researchers theorized that higher levels of stock option pay would cause CEOs to favor aggressiveness over thoroughness in their decisions, a consequence of which would be a higher likelihood of mistakes in the design, production and distribution of products.”

All measurement systems are flawed. Finally, the authors contend that any metric used to measure performance is going to be flawed, and that problem is compounded in the context of “a complex job such as senior management, [where] it is simply not possible to precisely measure someone’s ‘actual’ performance, given that it consists of many different stakeholders’ interests, tangible and tacit resources, and short- and long-term effects…”

Sidebar: See, for example, this PubCo post discussing the disparate views of CEOs and directors on appropriate measures of CEO performance and this PubCo post regarding the debate over the use of TSR as a performance measure.

And, the authors maintain, rewarding one behavior can distort other behaviors: “once you link someone’s financial rewards to a particular measure or set of measures, it is going to affect that person’s behavior – in terms of what they do, and don’t do….If you reward quarterly profits, for example, you should not be surprised if CEOs cut back inappropriately on long-term investments such as research and development and advertising when they need it to boost their numbers and hit their bonus target.”

SideBar: For another example, see this PubCo post, discussing the argument of Professor William Lazonick that stock-price-based performance targets may actually spur some executives to conduct stock buybacks to artificially boost stock prices.

In the interview, the author is asked about the nature of responses to the essay, particularly in light of how embedded the concept of performance pay seems to be. Interestingly, he observes that not many people deny that how we currently pay CEOs distorts their behavior. However, most think the answer to that problem is to offer better incentives and better measures, such as tying pay to long-term performance. But the author contends that these measures are still flawed because of the lack of clarity surrounding the terms “long term” and “performance”: “Yes, long-term performance is what the CEO is supposed to do. But how on earth can you measure this? And because CEOs are human, we know that any imperfect measure we’re going to use is going to distort their behavior. No matter what you do, you’re going to get it wrong.”

SideBar: See, for example, this Pubco post discussing whether the typical three-year performance period associated with stock grants is long enough.)

At the end of the day, the author insists in the interview that he is not just throwing out a radical idea to stir debate: “In this case I actually quite mean it in saying let’s make it 100 percent fixed. Even if only 30 percent of pay is flexible, you’re still going to get it wrong. You’re still going to distort behavior and your measure of performance is still going to be imperfect. It’s still going to end up destroying part of your intrinsic motivation. So this time I actually quite mean it. Make all of it fixed.”

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